Gift Exchange and Efficiency Wages

Charles K. Wilber

University of Notre Dame


            In Caritas in Veritate, Pope Benedict XVI builds on modern Catholic Social Thought through honoring the 40th anniversary of Paul VI’s Populorum Progressio. His central argument is an extension of the analysis of love and charity from Deus Caritas Est to address the economic, cultural, and political concerns of our world today. Since Leo XIII’s Rerum Novarum, the church has insisted on the fundamental principle of human dignity and urged various means of solidarity complemented by the principle of subsidiarity. Benedict does not revise or revoke these principles. He repeats and summarizes them. But “Charity in Truth” goes beyond this. The paragraphs in #36.3 and 36.4 cited below introduce a theme important to the encyclical and its application.

"The Church's social doctrine holds that authentically human social relationships of friendship, solidarity and reciprocity can also be conducted within economic activity, and not only outside it or “after” it. The economic sphere is neither ethically neutral, nor inherently inhuman and opposed to society. It is part and parcel of human activity and precisely because it is human, it must be structured and governed in an ethical manner.

The great challenge before us, accentuated by the problems of development in this global era and made even more urgent by the economic and financial crisis, is to demonstrate, in thinking and behaviour, not only that traditional principles of social ethics like transparency, honesty and responsibility cannot be ignored or attenuated, but also that in commercial relationships the principle of gratuitousness and the logic of gift as an expression of fraternity can and must find their place within normal economic activity. This is a human demand at the present time, but it is also demanded by economic logic. It is a demand both of charity and of truth."

            This is new and exciting to an economist like me. I have always thought of solidarity as a series of measures to complement or to correct, what “normal economic activity”, that is the market, could not achieve. What Benedict XVI argues, however, is that economic relations themselves can and should be an occasion for solidarity, guided by the philosophy of gift.

            What does this mean in real life? Let me explore that question by relating Benedict's position to Adam Smith's economics and then focus on the real life issue of worker-employer relations. Let me start with another quote from the pope:

"But the social doctrine of the Church has unceasingly highlighted the importance of distributive justice and social justice for the market economy, not only because it belongs within a broader social and political context, but also because of the wider network of relations within which it operates.  In fact, if the market is governed solely by the principle of the equivalence in value of exchanged goods it cannot provide the social cohesion that it requires in order to function well.  Without internal forms of solidarity and mutual trust, the market cannot fulfill its proper economic function." (§35)

            Adam Smith, widely recognized as the father of economics, had a clear understanding of many of these ideas, though he is rarely credited for this understanding.  Indeed, the Smith that is known to most modern economists is a caricature of the real Adam Smith.  The popular image of Smith represents him as arguing that the so-called invisible hand of the free market and the pursuit of self interest by individuals drives the economy to achieve the social good.  This view is captured in the oft-quoted lines from Book IV Chapter ii of the Wealth of Nations:

As every individual … endeavours as much as he can, both to employ his capital in the support of domestick industry, and so to direct that industry that its produce maybe of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the publick interest, nor knows how much he is promoting it … [B]y directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain; and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention (Smith, 1776, 456].

            However, a more careful reading of Smith’s writings, especially his Theory of Moral Sentiments suggests that he had a much more nuanced understanding of human beings than the one which assumes that individuals are driven solely by self-interest (see Sen, 1986).  Although he argued that self-interest has a strong influence on people’s behavior, he had a pluralist view of human nature, in which sympathy – the ability to perceive things from another person’s perspective – has an important role.  He also emphasized that ‘rules of conduct’ influence people’s behavior in a positive manner:

Those general rules of conduct, when they have been fixed in our mind by habitual reflection, are of great use in correcting misrepresentations of self-love concerning what is fit and proper to be done in our particular situation (Smith, 1759, 160).

            Moreover, his views on the role of self-interest leading to the common good are not so clear cut either.  For Smith, the way that the connecting principles of the economy, through the invisible hand, gives rise to order reflects the planning and handiwork of the Deity as designer (see Evensky, 1993).   He thought that “humanity, justice, generosity, and public spirit, are the qualities most useful to others” (Smith, 1759, 190), and seems to have believed while self-interest is useful in certain situations, these other virtues are useful in others.  Especially towards the end of his life he began to have doubts about the role of the invisible hand and self interest in yielding the common good.  In the “Additions and Corrections”  (which is the only major revision of the text) to the Wealth of Nations, published in 1784, he discussed how the mercantile system was distorting commercial society.  In his revision of the Theory of Moral Sentiments in 1789 (a book which had seen no earlier revisions), he added “a compleat new sixth part containing a practical system of Morality, under the title of the Character of Virtue” (Smith, 1976a, 319-20). In this revision he argues that society is comprised of a layered web of communities with divergent interests, and that these can result in the creation of destructive factions. He appeals to all people to place the well-being of society as a whole above that of their own factions, and stresses especially the role of statesmen in constructing such a moral society through their actions and by setting examples for others (see Evensky, 1993, 2005).  Indeed, for Smith virtue serves as “the fine polish to the wheels of society” while vice is ”like the vile rust, which makes them jar and grate upon one another.” (Smith, 1789, 244) Clearly, Smith sought to distance his thesis from that of Mandeville and the implication that individual greed could be the basis for social good.   As Evensky argues, for Smith “ethics is the hero – not self-interest or greed – for it is ethics that defend the social intercourse from the Hobbesian chaos.” (Evensky, 1993, 204). So Adam Smith, economist and philosopher, would be quite comfortable reading Caritas in Veritate.

            Now let me take up a specific issue within worker-employer relations. In the light of economists' claims about the importance of incentives for the operation of markets, is the treatment of work in Catholic Social Thought, and more particularly, the concept of gift in Caritas in Veritate, viable. An economist might argue that "humanization" of work may be impossible because of: a) the way markets create a bifurcation of people as consumers/workers, coupled with the competitive pressures that force business firms to become ever more efficient; and b) the consumerism which is rooted in human greed and the workings of the business system.

            Because of competition one firm cannot improve working conditions, raise wages, or democratize the workplace if the result is an increase in production costs. Competition from other firms will keep the costs from being passed on in higher prices and, thus, profits will decline. The bifurcation of people into consumers/workers means that what they prefer as consumers-- lower prices-- makes what they prefer as workers-- better working conditions and wages-- less obtainable. Reliance on the market as the primary decision making mechanism bifurcates the decision into separate areas. What people want as workers will not be ratified by those same people as consumers. Since competition is now worldwide, even a whole country faces difficulties in mandating workplace improvements that raise costs.

            The problem is reinforced both by human greed and the constant effort of business to promote consumption as the ultimate end of life. This creates constant pressure to reduce labor costs, undercutting attempts to improve the quality of work life. Thus, the only hope may be to change work organization in ways that are both humanizing and efficient.

            Let me present an example. Consider a business firm which employs workers and produces for the market. This relationship is not just a simple market relation. Unlike many markets in which the two parties enter into a transaction and that is the end of their relationship, the relationship here is very likely to be a relatively long-term one – sometimes for a month or a year, or more usually an indefinite period – and one in which the firm is not hiring a certain amount of labor services, but a certain number of explicit or implicit hours of labor. When the labor contract is made the employee knows his or her wage, but has not yet provided the labor services. The employer may not be able to monitor exactly how hard the employee works, especially in more complex jobs, even with supervisors, and the employee has a great deal of leeway about how much effort he or she will put into the job. The degree of effort, in turn, will depend on how the employee believes he or she is being treated by the firm. A symbol of this treatment is the wage paid, although other conditions of work also count.  This can be likened to a gift exchange (see Akerlof 1982): if employees believe that they are being well treated and well paid, they will in return be loyal to the employer and buy into the employer’s goals. The main point is that if they believe they are unfairly treated, they will not be loyal and feel no sense of duty to get the job done; they will shirk and only work the least amount that they can get away with, and may even sabotage the production process. If, however, they feel that they are treated more than fairly, they will feel satisfied with their job and proud of working for the employer, and therefore put in a great deal of effort. The result will be that if employers believe that this is the way their employees will respond, they will pay a fair wage and will try to provide a good working environment. Productivity and wages will be higher than if they did not pay a fair wage and provide for good working conditions. Moreover, there are likely to be fewer labor–firm disputes, which will have a positive effect on efficiency. And there probably will be less need for supervisory personnel.

            This story of a gift relation has some similarities with the standard efficiency wage theory. According to this theory employers pay workers a wage higher than the lowest needed to obtain workers. They do so in order to reduce shirking. At this higher wage workers would not like to get caught shirking and lose their jobs (something that they would not mind so much if they were paid the lower wage, since they could obtain another job at that same wage).  In the efficiency wage model, there is unemployment in equilibrium because the wage is at a level higher than the labor market-clearing level, and because firms have no incentive to reduce the wage since their profits will be adversely affected by lower productivity due to increased shirking. Unemployment and the higher real wage provide a carrot and a stick to workers which make them provide greater effort because of the fear of getting fired and becoming unemployed.

            However, the gift exchange story is different because it explicitly brings in the issue of fairness. People react well when treated fairly, and not well when they feel unfairly treated. The story involving fairness is not only more realistic than the one that only involves shirking and the fear of losing one’s job, but is also better able to withstand criticism as an explanation of high wages. Shirking can be avoided by giving workers the incentive of seniority rights without paying higher wages to all workers, and workers may fear being fired and losing their reputation as good workers and thus exert a high level of effort without being paid high wages (see Akerlof and Shiller, 2009). Moreover, in work which requires group effort and where the individual’s contribution is hard to measure, workers may free ride on the efforts of their colleagues while getting paid higher wages. The fairness argument is able to withstand all these objections.

            Another argument can be made for the importance of the gift relation in commercial affairs. Reliance on financial incentives can have the unfortunate result of driving out the moral dimension of decision making. The general idea that economic incentives may sometimes backfire has received some empirical support in recent years. Building on work in social psychology, Frey and Oberholzer (1997)[1] argued that the introduction of monetary payments may reduce the intrinsic motivation to behave altruistically or perform one’s civic duty. They illustrated this with questionnaire data about the location of a nuclear waste repository facility, showing that individuals were less willing to accept locating the facility in their community if they were offered monetary compensation.

            A growing experimental literature testing monetary incentives also suggests that financial incentives can be counterproductive. Gneezy and Rustichini (2000)[2] found that subjects answered fewer questions correctly on an IQ test if they were paid a small fee per correct answer, and that high school students in Israel collected less money towards charity if they were offered a small monetary incentive. In a field experiment on day-care centers in Israel, Gneezy and Rustichini (2000)[3] furthermore found that introducing a fine increased the number of late-coming parents. Consistent with this finding, several recent laboratory experiments suggest that the introduction of fines or minimum performance requirements can reduce performance (Fehr and Gächter, 2002; Fehr and Rockenbach, 2003; Fehr and List, 2004; Falk and Kosfeld, 2005). [4]

            Barry Schwartz, Professor of Psychology at Swarthmore College, argues that 35 years of research demonstrates that "incentives don't just fail; they often backfire."[5] He goes on to say that these studies show that financial incentives remove the moral dimension from decisions by, among others, corporate executives. Attempts to use an index to measure performance results in the index being manipulated to boost the index that the incentive bonus is based on even to the detriment of company welfare. This is clearly the case in the banking industry that took on excessive amounts of risk and became over-leveraged in the pursuit of bonuses. Concern for the welfare of their clients took a back seat.

            Economists have made a major mistake in treating love, benevolence, and particularly public spirit as scarce resources that must be economized lest they be depleted. [6] This is a faulty analogy because, unlike material factors of production, the supply of love, benevolence, and public spirit is not fixed or limited. These are resources whose supply may increase rather than decrease through use. Also they do not remain intact if they stay unused.[7] These moral resources respond positively to practice, in a learning-by-doing manner, and negatively to non-practice. Obviously, they can also be overused.

            People learn their values from their families, their religious faith, and from their society. In fact a principal objective of publicly proclaimed laws and regulations is to stigmatize certain types of behavior and to reward others, thereby influencing individual values and behavior codes. Aristotle understood this: `Lawgivers make the citizen good by inculcating habits in them, and this is the aim of every lawgiver; if he does not succeed in doing that, his legislation is a failure.  It is in this that a good constitution differs from a bad one.' [Nicomachean Ethics, 1103b]

            Habits of benevolence and civic spirit, in addition to heightened group consciousness, can be furthered by bringing people together to solve common problems. Growth of worker participation in management, consultation between local communities and business firms to negotiate plant closings and relocations, establishment of advisory boards on employment policy that represent labor, business, and the public, all are steps toward a recognition that individual self-interest alone is insufficient, that mutual responsibilities are necessary in a world where interdependence and imperfect information generate distrust and tempt individuals into strategic behavior that, in turn, results in sub-optimal outcomes.

            The way that I have juxtaposed ethically based behavior and self-interest might give the impression that they are always mutually exclusive. But proximity to self-interest alone does not defile morality. Moral values are often necessary counterparts in a system based on self-interest. Not only is there a “vast amount of irregular and informal help given in times of need”[8]; there is also a consistent dependence on moral values upon which market mechanisms rely. Without a basic trust and socialized morality the system would be much less efficient.

            Thus Pope Benedict XVI's argument in Caritas in Veritate that gift relations must exist inside normal economic activity has some support in economics as a real world possibility.

[1] Frey, Bruno S. and Oberholzer–Gee, Felix. “The Cost of Price Incentives: An Empirical Analysis of Motivation Crowding-Out.” American Economic Review, 1997, 87(4), pp. 746-755.


[2] Gneezy, Uri and Rustichini, Aldo. “Pay Enough or Don’t Pay at All.” Quarterly Journal of Economics, 2000, 115(2), pp. 791-810.


[3] Gneezy, Uri and Rustichini Aldo. “A Fine is a Price.” Journal of Legal Studies 2000, 29(1), pp. 1-17.


[4] See Fehr, Ernst and List, John A. “The Hidden Costs and Returns of Incentives: Trust and Trustworthiness Among CEOs.” Journal of the European Economic Association, 2004, 2(5), pp. 743-771;  Fehr, Ernst and Rockenbach, Bettina. “Detrimental Effects of Sanctions on Human Altruism”. Nature, 2003, 422, 137-140;  Fehr, Ernst and Gächter, Simon. “Do Incentive Contracts Undermine Voluntary Cooperation?” Working Paper No. 34, 2002, Institute for Empirical Research in Economics, University of Zurich;  Falk, Armin and Kosfeld, Michael. “The Hidden Costs of Control.” Working Paper No. 250, 2005, Institute for Empirical Research in Economics, University of Zurich.


[5] Barry Schwartz, "The Dark Side of Incentives," Business Week (November 23, 2009).

[6] Kenneth Arrow, `Gifts and Exchange,' Philosophy and Public Affairs, I, 4 (Summer 1972), pp.343-362.


[7] See Albert O. Hirschman, Rival Views of Market Society, p. 155.


[8] Kenneth Arrow, `The Gift Relationship,' p. 345.